Wednesday, July 11, 2012

The folks at ECRI, led byLakshman Achuthan, say that the U.S. economy is in a recession. We won't know for sure for quite a while, and the answer may depend on what one's definition of a recession is, but I'm willing to say we aren't in a recession, and I've got some charts and reasons to back me up. 17 charts, in fact.

This chart shows the real Fed funds rate, arguably the best measure of how "tight" monetary policy is. Every recession in the past 50 years has been preceded by a significant tightening of monetary policy, as the Fed tries to slow the economy and/or reduce inflation pressures. A high real funds rate pushes up borrowing costs all across the yield curve. This in effect starves the economy of funds, and shuts off weaker borrowers from credit. Today, however, conditions are the exact opposite. The Fed is actively encouraging borrowing by keeping real borrowing costs extremely low and supplying almost $1.5 trillion of excess reserves to the banking system to make sure there is no shortage of money.

The slope of the Treasury curve has traditionally been an excellent indicator of where the economy is in the business cycle. The curve is usually flat or negative in advance of recessions, and then flips to being very positive in the early years of a recovery. The first of the two charts above shows the difference between 2- and 10-yr Treasury yields, which is arguably the best measure of the yield curve's slope. The difference is usually very low or negative prior to recessions, because Fed policy is tight, pushing up short-term rates relative to longer-term rates. When the Fed becomes exceedingly tight, the market begins to sense that the economy is slowing down, and that in turn leads to expectations that the Fed will soon begin to lower rates; that causes the curve to flatten since short-term rates are projected to be lower in the future. Today the curve is still positively sloped by a decent amount, which means that the market expects the Fed to raise rates in coming years as the economy gradually improves. The second of the two charts above combines the real funds rate and the slope of the Treasury curve to show that every recession in the past 50 years has been preceded by a very high real funds rate and a negatively-sloped Treasury curve. Taken together, these two indicators suggest that the odds of a recession are very low.

Credit spreads are a good measure of how risky corporate debt is perceived to be. Credit spreads tend to rise in advance of recessions, because the Fed is restricting credit and making borrowing costs high. Moreover, the market senses that tight money is likely to slow the economy, and that puts weaker borrowers at greater risk of default. Swap spreads are arguably the best credit spread to focus on, because swap spreads have tended to be leading indicators of systemic risk and are direct indicators of the health of the financial system. In the chart above we see that swap spreads are very low, suggesting that the economy is not facing any unusual risks, the banking system is quite healthy, and there is no shortage of liquidity. Credit spreads are a little high, but this is mainly due to the fact that Treasury yields, the benchmark against which all credit yields are measures, are unusually low. The yield on A1-rated Industrial paper today is at an all-time low of 1.44%. Clearly, the market is not at all concerned about the health of these companies.

Credit Default Swap spreads, such as shown in the chart above, are very good and liquid measures of the average default risk of a large number of large corporate borrowers. Here again we see that spreads are somewhat elevated, but still far lower than they were during the last recession. Indeed, they have been trading around current levels for most of the past few years. On the margin, they have been declining, which would suggest that the risk of a recession has been receding of late.

Residential construction has moved in and out of slumps at the same time as the broader economy in every business cycle in the past 50 years. The recent housing slump was the worst and longest-lived, but it has finally reversed. Housing starts are up 48% from their recession lows. The beginnings of a housing recovery are also evident in the fact that both residential and nonresidential construction spending are beginning to turn up.

As of May, industrial production in the U.S. showed no signs of deterioration, having risen at a 4.7% annualized rate over the past six months, and rising 4.6% over the past year. Subtracting the output of utilities, manufacturing production is up at a 6.1% annualized pace over the past six months. The ISM survey of the manufacturing sector has been weak in recent months, but the index is still consistent with growth in the overall economy of 2% or so. (see second chart above) As of June, the ISM survey of manufacturing employment showed no signs of any weakness; indeed, it registered a relatively strong 56.6. If manufacturing conditions were deteriorating, the majority of firms would not be planning to expand employment.

The establishment survey of private sector employment has been relatively weak in recent months, but the household survey has been relatively strong. Neither survey shows any signs of turning down. The economy is weak, to be sure, but if employment continues to grow then I doubt this will prove to be a recession.

First time claims for unemployment have only ticked up marginally over the past few months. There is a lot of seasonal noise in this series, but no reason so far to suspect that the labor market is deteriorating, and that is confirmed by the Challenger tally of corporate layoffs, which is quite low.

Commercial & Industrial Loans outstanding continue to rise at double-digit rates. Banks are relaxing lending standards, and companies are willing to borrow, a good sign of rising confidence, and a clear sign that credit conditions, which have been very restrictive, are improving.

Consumer confidence tends to be a lagging indicator, and it remains quite low. Recessions tend to catch nearly everyone by surprise, especially consumers. Note how confidence is typically high going into a recession. Recessions happen when the future fails to turn out as expected; companies expand only to find that their market has shrunk; consumers borrow and spend, only to find that they've lost their job; builders build, only to find that there are no buyers. But with nearly everyone still quite pessimistic about the future, it is unlikely that businesses or consumers are "over their skis" and vulnerable to a slowdown. Caution still reigns.

Consumers have been deleveraging over the past several years, another sign of caution. As of last March, credit card delinquency rates continued to decline at a fairly impressive pace. Consumers have pulled back, and their balance sheets are healthier as a result. Households' financial burdens are about as low as they have been in the past 30 years. This effectively provides a cushion against recession.

There is no way to be sure about this, I'll admit. Plus, much of the data in these charts is a month or so old, and subject to revision. (Financial data such as interest rates and swap spreads, however, are as of today.) But I think the preponderance of the evidence suggests that the U.S. economy continues to grow, albeit at a relatively slow pace. Moreover, we have yet to see any of the classic hallmarks or leading indicators of recession such as we have seen in the past (e.g., tight Fed policy, rising swap spreads, rising unemployment claims, a flat yield curve, too much confidence).

13 comments:

The sooner that fiscal and monetary policy can hammer the US economy into a deep depression, the sooner that we can all buy up more equity bargains -- we live in an economy that was built for accredited investors with a 30-year plus investment horizon -- everyone else should be under cover...

PS: All of Scott's charts above seem to confirm that the US economy has declined sharply over the past five years -- in fact, the 5-year data reflects a near horrific economic state using a 5-year window -- pessimism is winning, folks -- those without means should remain under cover...

Thank you Scott. The recurring message I get from your generous posts is that the world is resilient, and though there are real and large risks, there is no reason to bet on the end of the world as we know it. I really appreciate your well reasoned arguments.

Well, Scott has used the post WW II, Standard Model for how recessions develop following the Federal Reserve raising interest rates to slow an OVERHEATED EXPANSION of the US economy.

It is of course a phony argument since the FED hasn't raised interest rates to slow an overheated economy - yet the economy is clearing slowing. Down from Scotts - and a few others - earlier prediction of 3.5% GDP growth in the first quarter of 2012.

Quite the contrary, the FED is doing EVERYTHING it can to keep interest rates out as far as 10 years near 1% or less with FED fund near 0%, QE and Operation Twist. YET, the US and many other economies around the world are slowing.

I doubt that the post WW II Standard Model of the etiology of recessions applies after a near fatal financial collapse that we experienced in 2008 - 2009.

AND as ECRI has pointed out for three years now, every US post recession recovery since the early 1980s has been weaker and weaker with progressively lower maximum GDP levels and less job growth. The old model of recession simply doesn't apply.

What Lakshman Achuthan actually wrote and said last December was that long leading indicators were predicting that the US would (by later official measurement) be found to have entered recession by the 1st quarter of 2012 or at the latest by mid year. But that most economists per usual would not recognize it because they mostly deal with only coincident or short leading indicators.

It would take until 6 months later before Wall Street and most economic forecasters would agree that the US was in recession.

He has provided examples of previous recession to illustrate the concept. For example, the recession which most people think followed the collapse of Bear Sterns and Lehman Brothers in 2008 was officially declared to have begun in December of 2007 -long before those events.

The S&P 500 peaked in October 2007, corrected with news of Bear Sterns in the Winter of 2008 then rose sharply into May and June of 2008 oblivious to the fact that a US recession had begun 6 months earlier.

His prediction has been that it will be the Fall before most folks understand that a new recession has begun. That's of course why no one believes him. We'll see. I hope that he is wrong too.

Folks, look at Scott's charts -- the economic picture those charts paint is gloomy -- people who are "singing in the rain" are nevertheless experiencing a rainy day -- sunny economics will certainly return in the future -- but as of right now, the economic weather is gloomy, plain and simple...

I agree that regular models don't work in this era. Also, I think ECRI has been right on their call directionally, but the timing was terrible (first recession call was 9/30/11 on both Bloomberg and CNBC). I ran the stock market returns for past ECRI recession calls back to 1970s and in only one case did you come out ahead by selling on the recession start date and buying back on the recession end date - that was the 2008 call.

I like ECRI alot, but it is not useful for stock market decisions in my opinion.